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Executives

Brian Dunn – IR

Shaw Hong – CEO and President

Ray Cisneros – VP, Worldwide Sales

Anson Chan – CFO and VP, Finance

Analysts

Yair Reiner – Oppenheimer & Company

Harsh Kumar – Morgan Keegan

Paul Coster – J.P. Morgan

Hans Mosesmann – Raymond James

Rajvindra Gill – Needham & Company

Betsy Van Hees – Wedbush Securities

Doug Freedman – Gleacher & Company

OmniVision Technologies, Inc. (OVTI) F3Q2011 Earnings Call Transcript February 24, 2011 5:00 PM ET

Operator

Ladies and gentlemen, thank you for standing by and welcome to the OmniVision Technologies conference call for the third quarter of fiscal 2011. At this time, all participants are in listen-only mode. Later we will open up the call for your questions. Instructions for queuing up will be provided at that time. As a reminder, this conference call is being recorded for replay purposes. I would now like to turn the conference call over to Mr. Brian Dunn. Please proceed, sir.

Brian Dunn

Thank you very much. Good afternoon, everyone, and welcome to our fiscal 2011 third quarter earnings conference call. On today’s call will be Shaw Hong, President and CEO; Ray Cisneros, Vice President of Sales; and Anson Chan, Chief Financial Officer.

During this conference call, we may make forward-looking statements regarding our business, including statements relating to revenues, earnings targets, and our product plans. This is based on information as of today, February 24, 2011, and actual results may differ materially from those set forth in such statements. These and other forward-looking statements involve assumptions, risks and uncertainties that could cause actual results to differ materially from those statements. For a discussion of these risk factors, you should review the forward-looking disclosures in the earnings release we issued today as well as OmniVision’s SEC filings.

During today’s call, we will also discuss certain GAAP and non-GAAP financial measures, the latter of which excludes stock-based compensation expenses and related tax effects. A reconciliation between the two is available in our earnings release posted on our website.

With that, I will now turn the call over to Mr. Shaw Hong. Shaw?

Shaw Hong

Thank you, Brian. And welcome to all of you joining us on the call and webcast. Earlier this afternoon, we issued a press release describing our resource for the third fiscal quarter of 2011. For those who have not read the release, I’m pleased to provide you with a recap of our financial results. In Q3, we achieved another quarter of record revenues of $266 million, a 11% quarter-over-quarter increase in sales. On a non-GAAP basis, gross margin was 30%, the eighth consecutive quarter of improvement in gross margin, and net income was $51 million or $0.84 per diluted share. This is another record for OmniVision.

In addition, we maintained a very strong balance sheet with a cash position of $499 million. Further, we shipped record volumes of image sensors, nearly 194 million units. This is the highest level of units ever shipped by OmniVision in a quarter, surpassing the record established in the prior quarter. We are extremely pleased with our record results for both revenue and earnings.

In my formal comments today, I will focus on three key topics. First, OmniVision’s leadership role in image sensor technologies and solutions, and our strategy to maintain that leadership; Second, the broad and rapidly growing market that we currently sell with our high performance imaging products; and third, a brief overview of our expanding global operational presence, which is one of the keys to our continued success.

First, I will discuss OmniVision’s leadership role in the advancement of image sensor technologies and solutions. In the technology space, the ability to innovate is what set the company apart. It is this ability and constant commitment to innovation that has contributed to OmniVision’s success. As the first company to commercialize backside illumination or BSI technology, we began volume production based on our OmniBSI technology in the first half of calendar 2010.

With our proprietary OmniBSI technology, we deliver the industry-leading imaging solutions that offer the optimal combination of low light image capture with excellent color reproduction and clarity. In calendar 2010, we delivered on our continued commitment to drive the rapid development of BSI technology with the introduction of our second generation OmniBSI-2 pixel architecture. As such, OmniBSI-2 represents the next logical step in our long-term BSI development effort.

OmniBSI-2 technology is our first pixel architecture built on 300 millimeter wafer using a copper process. The new process and design rules enable a number of substantial improvements over OmniBSI technology’s already impressive performance, including improved picture layout, better isolation, and significantly reduced crosstalk. OmniVision-2 technology also incorporates a more advanced pixel and provides us with added flexibility in next generation sensor designs.

The results include increased sensitivity, improved image quality, and enhanced color reproduction. We believe our proprietary expertise in the design and the production of BSI sensors is our key competitive advantage. For this reason, we remain committed to the ongoing development of products based on our original OmniBSI technology, which continue to enjoy strong demand.

As with OmniBSI, we expect to apply over time our next generation OmniBSI-2 architecture to the majority of our sensor products. However, we were first to apply these latest technologies to those sensors and are using premium multi-feature devices, which demand superior in performance with continuing to extend the OmniBSI architecture appropriate to those products with best advantage of its unique features.

Recently, at the Mobile World Conference in Barcelona, we announced our first image sensor, built on our OmniBSI-2 technology, the OV8830 image sensor. The OV8830 device is our most sophisticated 8-megapixel image sensor to-date. The advanced feature offered by this device enables full HD video. We set a new standard for the laterally growing video-centric smartphone market.

We remain on schedule, as we execute the planned tradition from sample volume to mass production of the OV8830 in the second half of calendar 2011. Meanwhile, we remain committed to advancing our CameraCube technology, which combines fully assembled image sensors advanced in one image sensor device. As such, this technology has the potential to increase the level of proprietary content that we build into each consumer device.

We continue to work with a broad range of customers to identify high volume applications that are also cost-effective. Our CameraCube products are entering volume production and are supported by increasing customers’ acceptance and the product demand. While we continue to raise our production volume, we are also aggressively working towards reducing production cost and improving sensor performance.

Turning to the markets we serve, I have several observations. Many of the established products markets we participate in have shown and continue to show tremendous rate of growth. Other segments include emerging markets where we strive to be the image sensor supplier of choice and there is projection for a number of our target markets such as the demand for CMOS-based imaging solutions is expected to triple or quadruple over the next two years. The common denominator among these markets is demand for high sensitivity, high definition images and videos.

I will now briefly comment on our three key markets; mobile phone, notebooks, and the rapidly evolving entertainment market. First, the mobile phone market remains one of our key markets and supports our continuing successes. Based on published report, mobile devices sales reached approximately 1.6 billion units in 2010. Smartphone continued to establish their importance in this critical market segment. Currently, we target estimates for smartphone volume at nearly 300 million units or more than 18% of total mobile device units. We believe that we are a leader in this market, which is driven by demand for the high performance image sensors in which we excel.

In calendar 2010, our 5-megapixel sensors set the benchmark performance among our top tier customers. In calendar 2011, we anticipate that our 8-megapixel sensor will be another strong product supporting smartphones and other high end devices, as our customers demand continued improvements in performance and resolution.

Next, the mobile market, which includes webcams, remains important to our direction. We believe there is room for additional penetration in this market segment, particularly as video conferencing become more prevalent in consumer and business applications. Concurrently, the demand for HD video capture is increasing. In the past, the market was generally serviced 4:3 format mainstream sensors ranging anywhere from VGA up to 5-megapixel devices.

However, we believe that 720p or 1080p HD video is becoming mainstream and that we would ship the range of HD sensors in increasing volume. Indeed, at the corporate level, certain higher end applications have already moved to our 5-megapixel sensors to deliver the optimal experience. This is an example of our strategy to be the leader in HD capable devices and to increase our sales into the premium device segment of a particular market. Given the superior performance our image sensors can deliver, we believe we are well positioned to hold this leadership position.

As for the entertainment market, this market may become our next breakout category because of the continued strength in customer demand for our products. In Q3, entertainment was 10% of revenues. Within this category, we included portable multimedia players, TV applications that feature gesture at recognition, as well as telepresence and interactive gaming systems. As many of you probably noticed over the December holiday season, and from news coverage at the Consumer Electronic Trade Show, gather an increasing number of exciting consumer devices we introduced.

One category, the tablet, saw upwards of 100 new products introduced at CES. The importance of this device is strongly anticipated. In fact, one tablet actually won best gadget at the show. We are working with many manufacturers of this next generation technology applications. Our goal is to continue to drive must-have applications that in turn will drive our financial performance for our stockholders.

Although not yet one of our top-three key markets, the automotive space is increasingly important to us with the broadening acceptance of image sensor technologies as a driving assistance feature. For the automotive market, we continue to provide our customers with the most optimal products based on our advanced front side illumination technology. Depending on automotive design cycles, this product can be mainly used for many years. In the quarter just ended, we capture several design wins for mid-level range car as well as SUVs. This is an addition to a number of luxury brand cars we already support.

I will now comment briefly on the scoop and the benefits provided by our global operations. In addition to innovation, our ability to serve our customers with the most effective global operations differentiates us from others. Our success is built on executing the following. First, we get many advantages from operating as a fabless company, which allow us to focus our efforts on our core expertise in image sensor design. We leverage our expertise through our long-term partnerships with the tier one foundries and other supply chain partners. This relationship has enabled us to focus on translating our technology developments into advanced imaging products.

Next, we continue to expand our team and offices to extend operational presence worldwide. The latest office location is in India. And we have had a much positive customer feedback in that region. Our goal remains to fortify an already solid infrastructure, deliver real-time and around-the-clock support to our customers and supply chain partners, and meeting our commitment and achieving our strategic goals.

Before I turn this call over to Ray, I would like to reiterate that our record performance is based on our continued efforts in focusing on technological advancement, delivering high quality products, meeting customers and the consumer demands, ensuring our customers and supply chain partners with at most care. Our development of BSI architecture, our mass production of BSI-based product, and the growing market acceptance of these products underscore the sound execution and the implementations of our longstanding strategy.

With that, I will turn the call over to Ray who will provide an update on the quarter’s sales activity. Ray?

Ray Cisneros

Thank you, Shaw. We are extremely pleased to report record revenues and record volume shipments for the second consecutive quarter. Our results reflect a wealth of positive converging factors, including a strong seasonal cycle, a healthy group of premiere customers, our engagement with some of the fastest growing markets and our leading market position fueled by our BSI products. In the quarter, we continued to ship record volumes of BSI-based sensors, including 5-megapixel, 8-megapixel, 720p HD, and even a specialized VGA device.

During the third quarter, we also continued to broaden our reach into our target markets, customers and applications with our extensive portfolio of products and technologies. And finally, we are proud to say we have secured major design wins with products using our second generation backside illumination technology, OmniBSI-2.

I will now focus on our business components. In our third fiscal quarter, we shipped a record high of nearly 194 million units as compared to 185 million units in our prior quarter. The average selling price in our fiscal third quarter was $1.37 as compared to $1.29 in the prior quarter. The sequential increase in the average selling price was driven by a shift in our product mix, mainly due to continued strength in the demand of our high resolution BSI-based sensors.

In the third quarter, unit sales of sensors 2-megapixel and above represented approximately 33% of total shipments as compared to 28% in the prior fiscal quarter. In this category, our industry-leading BSI-based 5-megapixel sensor continued to ship in large volumes. Our BSI-based 80-megapixel image sensor also drove strongly in the seasonal cycle. Lastly, we continued to share the significant number of two megapixel sensors into the mainstream future handset market.

Unit sales of 1.3 megapixel sensors represented approximately 11% of total shipments in the third quarter as compared to 12% in the prior quarter. In this category, we include our industry-leading BSI-based, 720p HD sensor, OV9726. We continue to ship this part at a high volume pace, mainly driven by mobile multimedia devices. In the coming quarters, however, this sensor will be shipping into the notebook market, setting a new standard performance in this segment.

Finally, unit sales of sensors that were VGA and below represent approximately 56% of total shipments in the third quarter as compared to 60% of unit shipments in our prior quarter. This category maintains a significant shipment volume, because as previously mentioned, premiere customers requiring best performance out of their secondary camera and the smartphone product implement our specialized VGA sensors.

These sensors have a 3-micron pixel that provides maximum performance for the best consumer experience during video conferencing, a trend OmniVision forwards in the marketplace. These large pixel sized VGA sensors are also being adopted in integrated notebook cameras as OEM manufacturers strive to maximize the image performance in their video conferencing applications.

In terms of product markets, our mobile phone sales represented approximately 72% of our revenues in the third quarter as compared to 66% in our prior quarter. Our sales of sensors into the notebook and webcam segment were approximately 10% of sales compared to 15% reported for our prior quarter. Our entertainment category represented 10% of sales as compared to 11% last quarter. The balance of our sales backed into our other market categories, mainly in security, DSC and DVC and automotive.

Our strong mobile phone revenue continues to be driven by the smartphone market. We are extremely pleased with our engagement with some of the premier smartphone leaders in the market today. Our relationships run deep with these customers as we continue to engage with them on a strategic level for next generation developments.

Additionally, we are now seeing increasingly strong demand for sensors by premier OEM makers in the Far East for aggressively launching their own smartphone products. These customers are targeting to use our BSI-based 0.25-inch 5-megapixel products as the primary camera possess secondary camera.

Another key development in the smartphone market is the migration to an 8-megapixel resolution sensor the primary camera. We have already been shipping this product resolution to the smartphone market for several months. However, the volumes will grow significantly in the second half of this calendar year and 8-megapixel sensors will become the product of choice by next year.

As Shaw noted earlier, we recently announced at the Mobile World Conference in Barcelona, Spain, the launch of an 8-megapixel sensor, the OV8830, which is based on our next generation BSI technology, OmniBSI-2. We have targeted the 8830 for mass production by this year’s fall season and have already secured design wins with multiple Tier 1 OEM manufacturers.

The 8830 will be our third 8-megapixel image sensor right on the heels of our two other successful 8-megapixel sensors based on our first generation BSI pixel OmniBSI. As we took leadership in the 5-megapixel sensor for the smartphone market, we anticipate the 8-megapixel will repeat our success story.

In the notebook and webcam segment, we continue to ship a wide range of products from VGA up to 5-megapixel. Similar to the secondary camera and smartphone products where the customer is interested in the best video stream while keeping the data volume low for faster transmission rates, some of our notebook customers are choosing to use our specialized large pixel VGA or BSI-based VGA.

Another trend that is ramping fast within the next several months is the incorporation of our BSI-based 720p HD sensor. This reflects the trend of growing demand for native 16:9 video capturing. In all these cases, OmniVision shows its leadership in innovation and commitment to keep adding value to products that we sell to our customer base.

In the emerging market segment, we continue to ship significant volumes into the mobile multimedia entertainment product category. On another front, the tablet-type products have gained a lot of attention. In this category, OmniVision is set to deliver significant volumes in the coming months to OEMs located in several regions. All third-party services indicate the tablet market is poised to drive significant volumes for the semiconductor industry.

Another emerging market that will add growth to OmniVision in the coming months is the television segment. We are engaged with many major TV OEM brands with plans to use image sensors for a variety of applications. These include power saving factors, hand jester recognition functions, and video cameras for conferencing or interactive gaming. For video conferencing, in particular, the emerging trend for Internet-connected TV will be the driver behind the growth of that product category.

Before moving on to the product’s discussion, I want to make some brief comments on other key emerging markets that we serve. We continued to win key socket designs in the automotive and medical space. These applications build up volume at a slower pace, but in the long-term, we are confident they will add significant volume and revenue to our business.

We are actively engaged in the next round of socket designs in the DSC and DV camcorder space. In particular, in the more prominent Japanese market. In security, the trend to IP camera-based surveillance is now driving volume for us and will continue to grow. In gaming, we continued to ship significant volume to a Tier 1 OEM for their tabletop and mobile devices, and we are actively engaged with all key OEMs in their next generation planning cycles.

From the products perspective, OmniVision announced several major devices. As previously mentioned, the OV8830, our 8-megapixel and first image sensor based on our OmniBSI-2 pixel architecture, is targeted for mass production in the late summer season. We have positioned this product for a variety of key markets, including the smartphone DSC, DV cam and other mobile applications.

Key customers are working with us for their critical ramp-up plans, and we are planning for significant production volumes. It’s a one-third inch form factor, naturally inserts into many socket designs that are currently using our OmniBSI technology 5-megapixel sensor in a variety of mobile applications.

On our first generation BSI platform OmniBSI, we launched two new products, the OV10810 and the OV8820. The former is a 10-megapixel BSI-based sensor targeted for the hybrid DSC and DVC emerging segment. It offers the ideal combination of high resolution, still image captures plus native 1080p HD video capture mode at 30 frames per second.

The second product, the OV8820, is another 8-megapixel sensor designed for the smartphone market. Early ramp of volumes will start in the fiscal fourth quarter. The final product to note is our OV6930 that we launched recently. This sensor is designed for the medical market and at 1.8 x 1.8 millimeter, it is offering one of the smallest packaged footprints, making it ideal for endoscopy and applications.

In summary, we are in a very strong position to continue growing our business, leverage our technology for value-added solutions, and open up new markets with our innovation.

Shaw Hong

Thank you, Ray. I will now turn the call over to Anson, who will discuss our third quarter financial performance and provide guidance for our fourth quarter of fiscal 2011.

Anson Chan

Thank you, Shaw. And good afternoon, everyone. For the third quarter of fiscal 2011, we have reported revenues of $265.7 million, up 10.9% sequentially and 69.3% on a year-over-year basis. Direct sales to OEMs and VARs accounted for 80.2% of our revenues in the third quarter of fiscal 2011, up from 73.9% in the second quarter. The remainder of our revenues came from sales through our distributor channels.

Our fiscal 2011 third quarter gross margin was 29.8%, which marked further improvement from the 28.2% that we reported in our prior fiscal quarter. Excluding stock-based compensation expense of $472,000 included in cost of revenues, our non-GAAP gross margin was 30%, up from 28.4% in the second quarter.

In the third quarter, we recorded approximately $5.6 million for the sale of previously written down inventory and $2.9 million as an additional allowance for excess and obsolete inventories, with a net $2.7 million of unfavorable impact on our gross margin. In the second quarter, we recorded approximately $3.4 million for the sale of previously written-down inventory and $5.3 million as an additional allowance for excess and obsolete inventories, with a net $1.9 million of unfavorable impact on our gross margin.

Now as a reminder, there are seasonal cycles in our business. And our fourth fiscal quarter is typically is a slower quarter. This is also a time when we will ship mostly existing products while significant shipments of our next generation products would typically take place in the new fiscal year. As such, we do not expect any significant movements in gross margin in the fourth quarter.

R&D expense in the third quarter of fiscal 2011 totaled $23.1 million, a 10.6% increase from the $20.9 million in our second fiscal quarter. The increase in R&D expense was caused by our release of additional mass designs, which increased our NRE charges. We currently expect our R&D expense in the fourth quarter of fiscal 2011 will increase slightly from the third quarter level. R&D expense in the third quarter included approximately $2.3 million of stock-based compensation expense. Excluding stock-based compensation expense, third quarter R&D expense was $20.8 million as compared to $18.4 million in the second quarter.

SG&A expenses in the third quarter of fiscal 2011 totaled $15.4 million as compared to $14.7 million that we reported in the previous quarter. We expect SG&A expenses to remain comparable in the fourth quarter of fiscal 2011. Our third quarter SG&A expenses include approximately $2 million of stock-based compensation expense. Excluding stock-based compensation expense, SG&A expenses in the third quarter totaled $13.4 million as compared to the $12.6 million that we reported in the prior fiscal quarter.

Our GAAP operating income in the third quarter totaled approximately $40.7 million as compared to the $31.8 million in the prior quarter. Our GAAP pretax income in the third quarter totaled $42.1 million as compared to $31.0 million in the prior quarter. Other income and expense in the quarter included a non-cash gain of $1.2 million due to the revaluation of two interest rate swaps that we entered into when we purchased our corporate headquarters buildings in Santa Clara back in 2007.

Our GAAP tax rate for the third quarter was a benefit of 6.2% and resulted in a GAAP benefit from income taxes of $2.6 million as compared to a provision of income taxes of $2.1 million in the prior quarter. Included in our GAAP tax rate for the third quarter were several one-time adjustments. The first one was the reversal of certain previously recorded tax reserves when the statute of limitations for the related tax matter expired. And this reversal resulted in a one-time non-cash tax benefit of approximately $10.3 million. This was offset by the recording of a $7.3 million tax charge when the company prepared itself for the future distribution of earnings among its foreign entities.

Lastly, the administration’s retroactive expansion of federal R&D tax credits in December provided an additional tax benefit to the company in the third quarter. Excluding the effective stock-based compensation, our non-GAAP tax rate for the third quarter was a benefit of 8.6% and our non-GAAP benefit from income taxes was $4 million. This compares to our non-GAAP tax provision for the second quarter of $1.8 million. For the fourth quarter of fiscal 2011, we expect our GAAP and non-GAAP tax rates will go back to single-digit percentages.

In the third quarter, our GAAP net income attributable to OmniVision was $44.7 million or $0.75 per diluted share as compared to GAAP net income attributable to OmniVision of $28.9 million or $0.50 per diluted share in the second quarter. Excluding non-cash stock-based compensation expense, our non-GAAP net income attributable to OmniVision for the third fiscal quarter was $51.0 million or $0.84 per diluted share. This compares to non-GAAP net income attributable to OmniVision of $34.2 million or $0.58 per diluted share in our second fiscal quarter.

Let me now turn to the balance sheet. We ended the third quarter with cash, cash equivalents and short-term investments totaling $498.9 million. This compares to $396.7 million at the end of the second quarter. A significant portion of cash increase came from cash generated by business operations during the quarter. The company also received a certain amount of cash when employees exercised their stock options during the quarter.

As of January 31, 2011, inventory totaled $93.6 million, a decrease of $27.7 million or 22.8% from the $121.3 million balance at the close of our second quarter. Our January inventory balance represented an annual inventory turn of 7.9 times or 46-day sales. This level of inventory is much lower than our stated goal of 75 to 90-day sales. However, as we enter our slower fiscal fourth quarter, the steps we put on our supply chain should alleviate. Meanwhile, we will continue to work with our supplier partners to meet ongoing demand for our products.

Accounts receivable at the end of our third quarter net of allowances were $119.1 million, an increase of 5.3% from the $113.1 million at the end of our second quarter. Overall, our accounts receivable remained in excellent shape. Our days sales outstanding remained comparable at 41 days in the third quarter as compared to 43 days for our second quarter.

Now I will turn to our outlook for the fourth quarter of fiscal 2011, which ends on April 30, 2011. Once again, factoring in the seasonal pattern of our business, we currently expect that 2011 fourth fiscal quarter revenues will be in the range of $240 million to $260 million. Our GAAPO earnings are expected to range from $0.48 to $0.61 per diluted share. Excluding the estimated expense and related tax effects associated with stock-based compensation, we expect our non-GAAP earnings will be in the range of $0.57 to $0.70 per diluted share.

Shaw Hong

Thank you, Anson. In summary, we are very proud of our fiscal 2011 third quarter results. I’d like to thank our employees worldwide for their commitment to excellent and their focus on execution. I assure you that we will continue to execute with the same intention and the precession throughout the coming quarters and years.

We are confident in our ability to capitalize on the growth opportunities presented by the image sensor market with our technology, financial strength, and longstanding history of delivering on our goals in coming months. We continue to work daily to translate these advanced technologies into critical product solutions that meet the needs of our customers in all target market segments.

Operator, we are now ready to take questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Your first question comes from the line of Yair Reiner from Oppenheimer & Company. Please proceed.

Yair Reiner – Oppenheimer & Company

Great. Thank you, and congrats on the good results. First question is on seasonality. I know you don’t guide beyond one quarter. But based on the design wins you have now, do you expect the kind of quarter-on-quarter trend going into your new fiscal year in July to be comparable what we’ve seen in years past?

Ray Cisneros

Hi, this is Ray Cisneros. I could talk a little bit about the marketplace and our customers and our products. I think that backs into those three points I just mentioned. Suffice it to say, year-over-year there are two main drivers here. Number one, the markets are expanding. We have more markets today than we ever imagined, even a year ago or two years ago definitely. So that’s one thing. The second thing is, we are firing on all cylinders in regards to products, technologies, and our customers in our work with our supply partners. So, all I can say is that we are happy in our position. We are extremely motivated on executing a year out from now. That’s the way your question comes to me. And we’re anticipating these kind of activities.

Yair Reiner – Oppenheimer & Company

Good. And then in terms of the ramp of BSI-2, I guess it sounds like you are a few months away from starting production volume kind of in earnest. Can you tell us about how that is going, where the yields are, and perhaps where you are at this stage relative to where you were a year ago with BSI-1?

Ray Cisneros

Yes. Let me talk a little bit about at a higher level. First of all, the way things operate in a company like OmniVision is technology-driven. Number one element to OmniVision is we’re extremely focused on technology. We are an R&D-based company, and that drives the right products. So that being said, every generation of technology, every product that OmniVision produces follows an engineering development phase that no different one from the other. So that has to be understood, that when we go through development, all these development cycles take a lot of resources, a lot of engineering work, a lot of production people to focus on it. And then at the end of the day, we execute on that plan. So when it comes to delivering products, we’ve been in this business now since 1995 and the only thing we’ve ever done is CMOS sensor products. And obviously, we’re good at this. We do it over and over and over again. So that’s the way we need to look at new products and technologies.

Yair Reiner – Oppenheimer & Company

All right. I have a little more – I'll just ask one more and then get back into queue. Your notebook revenues have been decelerating now for a number of quarters. Is there a product transition there? Is there different competitive landscape? If you could just tell us why the trends there tend to be quite different to what we are seeing in both your mobile and your entertainment categories. Thank you.

Ray Cisneros

Right. I think the way to address the question is a matter of looking again at a high level picture of the situation. Markets are expanding. New markets have come into play now this calendar year and next calendar year. And so, what OmniVision is doing is, given our products, our technology and our portfolio of customers, we have strategically started making our plans to work within the spaces of each of these vertical markets. So when you look at it, I would not say it’s an individual line item per se on a number. I would say OmniVision is strategically running with the right customers, with the right products, in the right markets. And this is the way we are approaching it. So if we look at our breakout if revenues, we now are breaking out a different line item just for the entertainment category itself. So we have to take that into perspective on how we want to manage our business and how we want to manage our customers and how we want to manage our revenues.

Yair Reiner – Oppenheimer & Company

Very good. Thank you very much.

Operator

Your next question comes from the line of Harsh Kumar of Morgan Keegan. Please proceed.

Harsh Kumar – Morgan Keegan

Hey, guys. Congratulations also on just some pretty tremendous numbers and growth. Your gross margin was up very nicely. Anson, I’m wondering if you could just give us some color on what the parts and pieces were and maybe give us some insight on to how much of the yield, how much of it makes one was bigger than the other, etc.

Anson Chan

Thank you, Harsh, first of all. When you look at the gross margin, I think I mentioned that last quarter as well. Since we are shipping BSI products for three quarters now, further enhancement via yield improvement, the opportunity is limited. So a lot of the change in this quarter is attributable to extremely strong demand out there. And in fact, some of the numbers that I highlighted on the prepared commentary about the sale of previously reserved inventory, it increased quite a bit, like $3.4 million in Q2 to $5.6 million. And that’s what we are seeing in the market. And those opportunities really drove the margin improvement significantly, not so much in a yield perspective. Hope that helps.

Harsh Kumar – Morgan Keegan

Yes, yes, that does help. Thanks. And then when we talk to people and then we do the checks on your company, we keep coming across people like – entry of people like Samsung and Sony. There has been a lot of talk about kind of mega players entering this market. I’m curious if you are starting to run into them at this point in time. If you can provide us with any sort of competitive update, we’d appreciate that.

Ray Cisneros

Hi, this is Ray Cisneros again. I think I’ll talk about a little bit of the competition in this way. The competition is going to be natural when these markets start expanding. These markets are huge. There is no marketing report that I could think of a year ago or two years ago that would have predicted the volumes that CMOS sensors and digital imaging technologies are driving today. So it’s a natural fact that there is going to be competition out there. Now, on the other hand, what differentiates, I think, our position is our ability to deliver products on time, our technology and our ability to work with our supply chains. Put that all combined, if you look at our customer base and our split of different products running with the latest technology we have, we feel very, very comfortable in the marketplace in whatever competitive landscape we come across.

Harsh Kumar – Morgan Keegan

Hey, very helpful. Thanks, guys.

Operator

And your next question comes from the line of Paul Coster from J.P. Morgan. Please proceed.

Paul Coster – J.P. Morgan

Yes, thank you. Ray, are there any Tier 1 handset OEMs that are seeking to bring 8-megapixel product market, the specifications for which OmniVision is structurally or tactically unable to meet?

Ray Cisneros

Yes. That’s a little bit of a question that a big portion of it we can’t talk, obviously what our customers are specifying to us in regards to particular products. But what we can say is, you know our announcements in terms of all our products with the latest technologies. And suffice it to say we are extremely, extremely confident, motivated, and prepared to execute on these plans.

Paul Coster – J.P. Morgan

Okay. And in terms of the margin outlook, some of us are a little bit concerned that margins may have peaked for a while in part because BSI-2 yield would be a little bit lower initially. And also there is a little bit of a concern that perhaps system capacity constraints at CSMC. Can you address those two questions?

Anson Chan

Yes, I can try. In terms of gross margins, I think I’ll go back to one of your comments about where we are in terms of current generation of BSI products. The timing of introduction of newer, even more advanced technologies. With that said, I just said on my prepare commentary as well, we are not going to see any near-term significant movement in gross margin, particularly in Q4. And most of the shipments still going to be OmniBSI based. I’ve also mentioned in prior quarters that as new technologies get introduced, regardless of this BSI, BSI-2, BSI-3, or you name it, there will be some initial year issues, and they may present itself as a headwind. But over time though, our long-term strategy is to continue to develop and deploy advanced pixels in technologies that can command a premium in the market. And so when it comes to product cycle, we will have an opportunity to expand margin again. Whether or not the concerns out there are having a significant effect or not, we all have to wait and see even internally. We’re still at an early stage for a product refresh, so to speak.

Paul Coster – J.P. Morgan

Very helpful. My last question is, did you have any 10% customers in the quarter? Can you give us some numbers if you did?

Anson Chan

Yes, we do. But again, these are the multi-manufacturers. Typically, we don’t talk about them until the SEC filings. So we ask you please wait till for the 10-Q.

Paul Coster – J.P. Morgan

Thanks very much.

Operator

Your next question comes from the line of Hans Mosesmann of Raymond James. Please proceed.

Hans Mosesmann – Raymond James

Thank you. Hey, Ray, could you just give us a little more granularity on the competitive dynamic as it relates to BSI specifically? What are you seeing out there in terms of your – the competition coming up to speed in the second half of this year? And how does your BSI-2 – how do you think that would compare with these early versions of BSI? Thanks.

Ray Cisneros

Sure. Obviously, from my position, I can’t speak for my competitors what they are doing, what they are not doing. I mean, the best I can tell you is what you read in the press out there is probably what I know as much as well. Maybe a little bit more, maybe not, but it’s difficult for me to conjecture. Now, on the other hand, going forward, we are more than ready, again as I mentioned previously, engaged with our customers. We have engagement with key customers. We have engagement with key products. We’re ready to go. We’re ready to hit our schedules. And that’s the most important thing I could say about the competition. We love our technology. Our engineers are doing a great job, and our production and supply management is executing on all cylinders, as I mentioned before.

Hans Mosesmann – Raymond James

Okay. One follow-on. Will VGA adapt to BSI technology over time?

Ray Cisneros

It’s a natural course obviously. But if there are – there are specifics when it comes to benefits, performance and cost trade-offs. As most of you are aware, there is a mix of these parameters that the customer has to consider. Today we do produce a specialized VGA based on BSI technology, and it’s got fantastic performance and attributes that the customer loves because of that and they are willing to pay a premium for that. That being said, over time, cost and efficiencies take place. And so we expect a natural migration of more and more.

Hans Mosesmann – Raymond James

Great. Thank you. Congratulations.

Ray Cisneros

Thank you.

Operator

Your next question comes from the line of Rajvindra Gill from Needham & Company. Please proceed.

Rajvindra Gill – Needham & Company

Hi, yes, congrats again on the stellar results. Question on the diversification strategy. You have about 70% of your sales, over 70% of your sales in the mobile handset business. What are you plans – you talked a little bit about it on the call, but what are your kind of concrete plans about diversifying our revenue? What the verticals you think offer the most opportunities for that diversification?

Ray Cisneros

It’s something that we are extremely anticipating quite a bit here on how verticals start playing out. Obviously the mobile vertical, it’s the 800-pound gorilla. You have to plan it. Luckily for OmniVision, we are I would say the leader in the smartphone segment of that vertical, which just is working out perfectly for us. When it comes to the notebook, the notebook quite frankly is still evolving. There is quite a bit of a trend in regards to the 16:9 format. That’s going to drive a lot of innovation that we are going to selectively strategize around.

And then when you get beyond the notebook segment, there comes a category that we are calling entertainment. That one is a broad, broad field. There is so much in there. Maybe in the future we might be able to delineate a little bit better, but at the moment, it encompasses anything from a tablet to a tabletop gaming device to mobile devices that provide media to the consumer. These three are the current drivers. Going forward in the future, I think we mentioned the security. The security market is extremely, extremely hot. That’s developing right now.

The IP camera segment of that market is growing fast, and we’re prepared for that with a variety of products. And then I would say the other key markets are the medical and the automotive. These particular markets are, I would say, on the incubation curve, for the medical in particular. And then the automotive, that’s where I see now volumes starting to accumulate and revenues starting to accumulate, and fantastic designs and automobile OEMs becoming more creative on how to implement cameras. As you well know, the automobile is destined or predicted to have multiple, multiple cameras. They do already, and even more so in the future.

Rajvindra Gill – Needham & Company

A question on the overall shipments, 2-megapixel and above was 33% shipments. Any color or metric that you could provide maybe on 5-megapixel and 8-megapixel relative to last quarter? And you mentioned that the 8-megapixel, you think, is going to be the standard camera on smartphones next year. Any sense of when do you think VGA will start shipping below that – start representing a smaller and smaller percentage of your shipments given the mix of 5 and 8?

Ray Cisneros

Right. So there’s a combination of factors here. In regard to the high resolution segment, obviously the 5-megapixel is still extremely strong. There was a quarter-over-quarter absolute growth in that particular resolution for us. We are very proud about that. The 8-megapixel is going to start ramping up at extremely high volumes very soon now. And that’s going to be all backing into the primary camera. We talked about the VGA. It kind of gets split into a couple segments here. The VGA is incorporated in the secondary camera smartphone devices. So that is, whether we like or not, we have to participate in that because it does a couple of things. Number one, we are adding the best product in the market, which is a very specialized VGA with high performance imaging. But it also protects our ecosystem.

So the same customer that buys a high resolution is looking for OmniVision to provide a secondary camera as well. The other part of the VGA business is to continue expansion of the entry-level handset business. This is so huge. It’s just not the Far East, but it’s also India and it’s also countries like Brazil. These countries have yet to see the dramatic growth cycles that we’ve seen in other countries and other emerging markets. So that my nature automatically starts with VGA. So from that standpoint, we have to leverage our supply chain, our economies of scale in terms of cost and innovation like wafer level modules.

Rajvindra Gill – Needham & Company

Okay. Excellent. Thank you very much.

Operator

Your next question comes from the line of Betsy Van Hees from Wedbush Securities. Please proceed.

Betsy Van Hees – Wedbush Securities

Thank you very much for taking my questions. First and foremost, congratulations on a phenomenal quarter and great guidance. I was wondering if we could go, Ray, to one of your comments you made on, I think I heard you correctly, and you said that you secured major design wins for your 8-megapixel BSI-2. Can you give us a little color around what end applications those are going into?

Ray Cisneros

Yes. I won’t go any further than just to say that I think right now we have to pay some respect to our end customers. We value that extremely. That’s a high value for us to maintain its confidentiality. All I can say is that the 8830, we’re extremely happy about its development stage right now. And we’re going to proceed on to our schedule. We are looking at second half of this year to run with it.

Betsy Van Hees – Wedbush Securities

Thanks, Ray. And while yields are very early on the stages of the 8-megapixel BSI-2, let’s say theoretically that you were to have yield issues. What steps would you take to improve your yields if, let’s say, that’s what would occur hypothetically?

Ray Cisneros

Hypothetical questions are hard to discuss in this forum. But it’s suffice it to say, as I mentioned, we’ve done this over and over again. We released products on a yearly basis, multiple products and multiple technologies. Multiple type of processes in our factories with our supply partners. And so we know what we are doing. We’ve done this many times before. The good thing about the BSI-2 is we have experience with BSI-1. And that automatically gives us a fantastic advantage, I would say, against our competition.

Betsy Van Hees – Wedbush Securities

Thanks, Ray. That was very helpful. And lastly, Anson, what are you going to do with all cash on the balance sheet?

Anson Chan

Well, we’re just wrapping up the third quarter. So it’s still – there is time for us to think through it. And obviously there’s not much we can talk about at this moment. But in due time, if we have any plans, we’ll definitely announce it publicly.

Betsy Van Hees – Wedbush Securities

All right. Thanks for taking my questions. And once again, congratulations.

Ray Cisneros

Thank you.

Operator

Your next question comes from the line of Doug Freedman of Gleacher & Company. Please proceed.

Doug Freedman – Gleacher & Company

Hi, guys, and thanks again for taking my question and I’ll echo the congratulations on very strong numbers. If you could help me clear up a little bit of confusion created by your BSI-2 launch, it looks like the 8830 is a 1.4 pixel. And I believe BSI-2, on your website, shows a 1 point – it being a 1.1 micron technology. When do you believe you will have the 1.1s ready for the market? And can you help me understand what is the difference between BSI-1 and BSI-2, if not the pixel size?

Ray Cisneros

Sure. So first of all, I can’t speak for the confusion you might see on our website. But definitely the 8830, the BSI-2 based product, that’s a 1.5 micron pixel BSI-2 product. In regards to the 1.1 micron pixel, obviously we have the capability with this technology to go down to 1.1 micron pixel. And we have the capabilities to demonstrate that privately to our Tier 1 customers, and we’re working very closely on planning strategies and product development roadmaps. So it’s not anywhere – it's not an issue with regard to migration to those levels and beyond for that matter. And in regards to – please remind me of your follow-up question. What was your second portion?

Doug Freedman – Gleacher & Company

Really just understanding the difference in the technology then between BSI-1 and BSI-2 if not the pixel size.

Ray Cisneros

Right. There is a wealth of differences. It’s apples and oranges. The BSI-1 is based on 8-inch wafers, aluminum-based metallization. And so that naturally drives a certain type of performance and certain type of image quality. When it comes to BSI-2, it is 12-inch wafers. It is copper metallization design, which starting at 90 nanometers and below. And automatically you have a wealth of benefits in terms of power, image performance and size. So you couple all that together, it’s a selection now that we will be able to offer our customers. We can go BSI-2, we could go BSI-1, and we can mix and match. We have a variety of tools not to attack the marketplace.

Doug Freedman – Gleacher & Company

All right. Terrific. And then just one for you, Anson. Similar to the last question, have you guys taken a look at, you know, are there acquisition opportunities out there? I believe there was a image sensor business in the last quarter sold. Did you guys take a look at that? And was there a reason why you didn’t participate?

Anson Chan

Maybe not specific to that company you’re referring to, but we do look at opportunities all the time. And if we can find something that’s either complementary or accretive to the business, and it makes sense. Obviously we’ll proceed. But it’s all depending on whether or not the appropriate type will come along.

Doug Freedman – Gleacher & Company

Great. Thank you so much, and congratulations.

Ray Cisneros

Thank you.

Operator

At this time, I’d like to pass the call back over to Mr. Brian Dunn. Please proceed, sir.

Brian Dunn

Thank you all for joining us on this call and webcast. In the upcoming quarter, OmniVision will be attending the JP Morgan Tech Conference in Philadelphia on March 8th. We hope to see many of you at that event. Thank you and good day.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Have a great day.

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